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Thursday, November 4, 2010

Volcker warns of inflation risk with Quantitative Easing

When he was about to take office after the 2008 election, I was surprised that Barack Obama named Paul Volcker as one of his senior economic advisors. Volcker was one of the many architects of the 1980’s economic revival, relentlessly pursuing a tight money policy during his term as Chairman of the Federal Reserve Board. As economists go, Volcker is a conservative inflation hawk.

After many years of loose money policies at the Fed, combined with progressive fiscal strategies from the Carter White House and Congressional Liberals, the country was literally on its economic knees. Volcker slammed on the brakes at the Fed, with the central bank regularly tightening credit to reduce the money supply and rein in inflation. That, combined with the new Reagan fiscal and tax policies, put the country on a record run of growth and prosperity. That run, according to many, persisted right through the Bush 41/Clinton/Bush 43 years, ending only with the financial collapse of 2007-2008.

So, when a man like Volcker warns that Ben Bernanke’s second round of quantitative easing (flooding the banking system with liquidity) could have inflationary consequences down the road, everybody should take heed.

“It does worry people” that “we’re going to create so much money that down the road we’ll create inflation,” Volcker, 83, said in response to a question about the global implications of quantitative easing at an event at the National University of Singapore today. “I don’t think that’s beyond the capacity of the central bank to deal with in the future. But they’re going to have to deal with it.”

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“It doesn’t alarm me that they’re thinking about buying Treasuries,” he said, referring to quantitative easing. “It’s the volume which they choose to do and we don’t know what that is,” he said, adding that “if money is too easy for too long, we’ll have more” asset bubbles.

As Fed chairman from 1979 to 1987, Volcker raised interest rates to as high as 20 percent to tame inflation, triggering a recession. “Dealing with inflation and inflation potentials is always a challenge,” he said. “It’s manageable but not easy.”

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[New financial regulations] include limits to investments by commercial banks in private equity or hedge funds, known as the “Volcker Rule” because of Volcker’s advocacy for the change. Under a measure that may not take full effect for as long as a dozen years, banks can invest in private-equity and hedge funds, though they will be limited to providing no more than 3 percent of the fund’s capital. Banks also can’t invest more than 3 percent of their Tier 1 capital.

Quantitative easing, or QE, is a massive infusion of cash from the central bank. The Fed buys billions in outstanding Treasury securities from member banks, in the hopes that the member banks will ease credit, begin lending more and stimulate the economy through capital investment.

The problem is, the return on capital is so low right now that banks and captains of industry are more likely to seek a less risky, albeit smaller rate of return by parking the new cash in short term, safe cash accounts and short CD’s. Until capital demand rises enough to make the return on capital worth the risk of investment, little expansion occurs and there’s no new employment. The cash sits on the sidelines in an economic phenomenon known as a “liquidity trap.”

The risk is that the return on capital does begin to move, and then begins to move rapidly, as all of that liquidity suddenly comes off the sidelines and starts chasing a limited supply of capital goods and the goods and services produced by the economy. As more cash chases relatively fewer products, prices rise in a ruinous inflationary cycle, similar to what was seen in the late 1970’s. It’s a real, but longer term threat that won’t likely be fully felt until late 2011 or 2012.

The Fed would have to combat that in much the same way Volcker did in the early 80’s, and the consequences would be exquisitely more painful now than they were then. In the 1980’s, if the US economy sneezed the world caught cold. Today, if the US economy sneezes, China and the rest of the world’s emerging economies would die of pneumonia.